From The Boomer & Echo Mailbag: Should I Sell My Bond Fund?
Q. The Bank of Canada has raised its interest rate a couple of times so far and there may be more hikes in the near future. I own a bond mutual fund in my RRSP and I had been told I should dump it before interest rates go up, but I’ve held on so far. Do you think it’s time to sell my bond fund? I’m not sure how this works.
I know it’s disconcerting to see your bond fund lose value, but that’s not a good reason to abandon it.
Why do bonds lose value when interest rates increase?
If you bought a new issue bond for $10,000 with a coupon rate of 2% you will receive $200 every year until the bond matures. If the interest rate for a similar bond rose to 3%, there wouldn’t be any consequences to you if you held on to it until maturity (as long as the issuer didn’t default). You would still get your $200 payments and the full $10,000 at the end of the term (although you’d have a loss of purchasing power because rising interest rates usually mean an increase in inflation).
But, what if for some reason you wanted to sell your bond in the secondary market. No one will want to buy your piddly 2% bond when they could get 3%. You have to sweeten the deal by reducing the bond price, so the yield would be comparable. Say you sold your bond for $9,650 (the actual market value will depend on such things as your interest rate, current interest rate and the length of the term remaining) – $350 will be a capital loss to you.
Bond mutual funds and ETFs hold multiple bonds of different types and terms depending on the fund’s mandate. When interest rates rise the unit price of the fund will fall in price, reflecting the market value of the underlying bonds – but the coupon rates don’t change so the total value includes your interest payments. Gradually, as older bonds get sold at maturity and are replaced with newer, higher-yielding bonds, the distributions will increase.
The total annual return isn’t going to show up on your investment statement. You have to visit the website and click on the “performance” tab. You will see that the total return includes price changes and reinvested interest payments.
That being said, even if interest rates do continue to rise your bond funds probably will give negative returns even when accounting for interest payments. However, you need to remember why you invested in the bond fund to begin with.
The fixed income portion reduces the overall volatility of your whole portfolio. And, this is also the opportunity to rebalance and buy more at the lower price and reap the benefits of future higher yields.
would you consider other investments like preferred shares (XPF) to be alternative choice or perhaps to be used in conjunction with a bond ETF?
@CJlizzard: Investors like preferred shares as an alternative to corporate bonds as they tend to have a higher yield. But, the price is still sensitive to interest rate fluctuations.
Also, take into account that preferred shares are slightly riskier than bonds. Bond interest payments are more secure but pref. share payments are not guaranteed and can be suspended. Bonds are often secured by company assets and get first dibs on payout over pref. shareholders. Carefully check the ratings of individual shares.
On the plus side, in a non-registered account the payments are treated like dividends so get better tax treatment than bond interest.
Look for preferred shares with rate resets. An example of a rate reset ETF is BMO S&P/TSX Laddered Preferred Share Index (ZPR)
I agree, there is a poor understanding by some investors about why they own bonds. You don’t own bonds for returns (you own stocks for that). You own bonds to decrease the volatility of the portfolio so you don’t panic sell stocks in a crash – the Big Mistake. If you don’t need that volatility suppression effect, (most people do), you don’t need bonds.
Another important point about bond funds, is that the price drop that occurs when interest rates rise is only temporary. Hold the bond fund for it’s duration and you will get your money back, due to the higher coupons of the the new bonds being purchased at the higher interest rates, as the older bonds mature. So all this talk in the media about bonds losing money in a rising interest rate environment is misleading and simply not true in the context of a long term portfolio.
Great article and insightful comments!
I have always wondered about bond funds rebalancing and selling off the decling bonds at a loss in order restore balance.
I may not do that with individual bonds I hold. Do bond funds have any reason or abilty to hold bonds to maturity? Especially the laddering type like CBO?
Hi Marc. Active mutual fund managers have the discretion to buy and sell bonds as they see fit, but ETFs follow an index and there’s little trading done. A bond fund’s duration shows the average term for its holdings. But, just because the duration is, say 6 years, it doesn’t mean that they will all come due in 6 years. They will have various maturity dates, some now and some later, and new higher interest bonds will be purchased. That’s also the idea behind laddered bonds – they will mature each year and roll over into new ones.